Guarded confidence

In June, the Markit PMI for the eurozone manufacturing sector was almost 6 points below its peak in December 2017, whereas the same index for the US has essentially been stable over the same period. However, the eurozone index (54.9) is now only slightly below the US PMI (55.4), which reminds us that focusing too much on the decline of the index stops us from noticing that it is still at a level that corresponds to robust, above-potential growth. Moreover, in June we witnessed a stabilisation (in the European Commission’s Economic Sentiment Indicator) or even some improvement (in the Markit Eurozone Composite PMI and in service sector PMIs in several countries) of survey-based indicators. To the extent that this is confirmed in the coming months, it would imply that softer sentiment in the first half of the year was part of a normalisation process after the feeling of euphoria in the latter part of 2017. In any case, the economic fundamentals of job creation, some acceleration in wage growth, low interest rates, growth in corporate profits and rising levels of capacity utilisation justify this type of reading.

In the US, sentiment remains globally speaking at a high level. The ISMManufacturing Index increased to a reading of 60.2 in June (from 58.7 in May), and the press release noted greater business strength, low inventory levels and increasing order backlogs: “demand remains robust, but the nation’s employment resources and supply chains continue to struggle”[1].

The quarterly Duke University ‘s Fuqua School of Business / CFO Magazine Global Business Outlook of 228 US firms paints a similar picture of strength with confidence stabilising at close to a historic high, making attracting and retaining qualified employees the top concern. But on the other hand, the unpredictability of US tariff policy starts to be a source of worry for CFOs. In some industrial regions deeply involved in external trade like Philadelphia, the business climate is not as good as suggested by the ISM.

The feeling of confidence also transpires in central bank communication with Fed Chairman Powell stating that “The main takeaway is that the economy is doing very well”[1], whereas Mario Draghi stated during his most recent press conference that the moderation in second-quarter growth reflected “a pull-back from the very high levels of growth in 2017, compounded by an increase in uncertainty and some temporary and supply-side factors”, and he expressed the ECB’s confidence in the growth of private consumption, business and housing investment as well as global demand[2]. As a consequence, monetary policy visibility is high. The Federal Reserve wants to evolve gradually from a still-accommodative stance to a relatively tight monetary policy whilst being mindful of incoming data. The ECB has announced that in principle it will stop its net asset purchases at the end of this year and has committed to keep its official interest rates at the current level at least through the summer of 2019.

Increased uncertainty

This favourable backdrop provides a certain resilience amidst increasing uncertainty, mainly for reasons of politics and economic policy. The former refer to the market turbulence during the final stages of the formation of the new government in Italy. The spread between Italian and German government bond yields widened significantly, and there was some spillover into the spreads of Spain and Portugal versus Germany. Moreover, the subsequent narrowing was incomplete so the bout of uncertainty did have a lasting impact. The focus of investors will also be on the Italian government’s new economic policy measures with respect to pensions and the labour market. Germany has also seen an increase in political uncertainty following the clash between the CDU and the CSU on how to deal with migration. All in all, the direct economic impact of these developments has been small or even non-existent, at least thus far. This is quite unlike the uncertainty related to trade policy, more precisely the threat of further increases in import tariffs. On the occasion of the ECB’s annual gathering in Sintra (Portugal) in June, Jerome Powell stated “Changes in trade policy could cause us to have to question the outlook,” whereas Mario Draghi said “It’s not easy and it’s not yet time to see what the consequences on monetary policy of all this can be, but there’s no ground to be optimistic on that”[3]. When we take into consideration the fact that protectionism generates uncertainty in several ways, both comments can be viewed as understatements, a matter of not scaring the audience too much. The mere threat of measures forces companies to analyse how they should adapt, which entails an opportunity cost. There is concern about retaliation and reaction to retaliation (a ‘tit-for-tat trade war’). At a macro level, there are worries about how much extra inflation will be created in the US by import tariffs and the impact on bond yields and monetary policy. In the longer term, tariff increases and higher inflation will weigh on the competitiveness of the protected economic sectors. According to the Institute of Supply Management in the US, “Respondents are overwhelmingly concerned about how tariff-related activity is and will continue to affect their business”[4]. Perhaps the sad irony of the matter is that the protectionist rhetoric will cool down only when the detrimental impact shows up in the data.

Emerging markets under stress

These developments compound the challenges faced by developing economies. The build-up of dollar-denominated corporate debt has made several of them particularly sensitive to the evolution of US bond yields and their exchange rate versus the dollar. After trending upward from September 2017 to early May this year, US treasury yields have now stabilised. However, the spread between the yields of emerging market corporate debt and US treasuries continues to widen and is putting pressure on corporate profitability and balance sheets. The prospect of more rate hikes by the Federal Reserve would mean that the pressure will remain, all the more so as world trade growth is slowing and creating a scissors effect: higher borrowing costs converted in local currency, slower growth. The protectionist threat complicates matters. World Bank research shows that developing economies are more sensitive than developed economies to uncertainty shocks[5] and tariff increases can have a considerable indirect impact via global value chains.